Option/Right to Exit

by Ms. Preksha Malik (B.A., LL.B. (Hons.) 2009 , JGLS

In January 2014, the Reserve Bank of India (“RBI”) permitted option/right to exist clauses in foreign direct investment (“FDI”) instruments by a notification amending the Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000 (“FEMA 20”). The welcomed step by RBI was in light of the clearance granted to call and put options and pre-emptive rights by Securities and Exchange Board of India (“SEBI”) through the notification dated 3^rd October 2013.

The Foreign Exchange Management Act, 1999 (“FEMA”) is the Act governing FDI in India, with RBI and Central Government as the regulatory authorities. Under Section 6(3)(b) and Section 47 of FEMA, RBI notified FEMA 20, which governs the nature of instruments that can be validly issued or transferred by a person resident outside India. Prior to the notification dated 6^th January 2014, FDI instruments with call and put options and pre-emptive rights, including tag-along, drag-along, right of first refusal and right of first offer, were treated as debt rather than equity and did not qualify as valid FDI instruments. In other words, instruments with optionality clauses would attract External Commercial Borrowing (“ECB”) Regulations rather than FDI Regulations and be subject to greater regulatory requirements. However, the clearance for option/right to exit clauses in FDI instruments was made subject to certain requirement and pricing guidelines, which were clarified in RBI notification dated 9^th January 2014.

The highlights of the January notifications are:

• Optionality clauses have been permitted for equity, compulsorily and mandatorily convertible preference shares and compulsorily and mandatorily convertible debenture.
• Minimum lock-in period requirements have been imposed, with the minimum lock-in period being one year or minimum lock-in period as prescribed under FDI Regulation, whichever is higher.
• The exit shall not be at an assured price.
• The regulations apply prospectively.
• RBI prescribed exiting pricing guideline for instruments with optionality clause issued/transferred under FEMA:
• Non-Resident + Listed Equity + Optionality clause
• Exit at market price.
• Non-Resident + Unlisted Equity + Optionality clause
• Exit at not more than Return on Equity based price as per the last audited balance sheet.
• Compulsorily Convertible Debentures (“CCDs”) and Compulsorily Convertible Preference Shares (“CCPs”) + Optionality clause
• Exit at price as per any internationally accepted pricing methodology duly certified by CA/Merchant Banker.

The acceptance of option/right to exit clauses by RBI is rooted in incentivizing FDI in India. Although, the acceptance came with the introduction of a dual scheme for without and with option instruments, the hitch in the notified dual scheme is magnified in case of unlisted equity that stipulates entry and exit at a price determined by Discounted Cash Flow (“DCF”) in case of without options, however limits the exit price to Return on Equity (“ROE”) in case of options. The scheme mandates a person resident outside India to enter at a price not lower than the estimated value of the entity, however, the exit price is limited by the book value of the entity. The scheme notified although approved option/right to exit clauses in case of unlisted companies, the financial unprofitable pricing guidelines have nullified the approval.

The acceptance of optionality clauses for equity, CCD and CCPS is a sign of a more liberalized FDI regime with a drawback of the dual pricing scheme. However, the present drawback with optionality clauses would be dealt with once the proposed FDI guidelines based on accepted marketable practices repeal all the existing pricing guidelines. The validation of optionality clauses coupled with the proposed pricing guidelines is expected to pump more FDI in India, thus benefiting the economy.